Adjustable Rate Mortgages (ARMs) and Mortgage Rate Calculators

By Sheryl Landrum
Calculators for Mortgages Columnist

Email this Article | Format for printing

While adjustable rate mortgages (ARMs), are certainly not as popular as they used to be, they are available to borrowers buying new homes or refinancing existing ones. However, they are not for everyone and before you decide to opt for one make sure you understand the basics and the risks behind them to ensure that you have a mortgage you can afford - for the long term.

The ABCs of ARMs

When pricing an Adjustable Rate Mortgage (ARM) your lender may offer you something like a 5-year interest-only LIBOR rate @ 6.25% with a 2.25 margin and caps at 5/2/5. Just what the heck does this mean?  

• The five year interest-only at 6.25% means that for five years your mortgage interest rate will be fixed at 6.25% and you will be required to pay only the interest on the mortgage and none of the principle.
• Once your initial interest rate (in this case the 6.25%) begins to adjust, your interest rate, and any future adjustements are determined by an index and margin. The index is a published rate that reflects trends in financial markets. Common indexes are the LIBOR, U.S. Treasuries, or the COFI. The margin is what is added to the index and covers the lender's expenses and profit margin. The index plus margin is called your fully-indexed interest rate. So if the LIBOR is at 3.75% when your rate is ready to adjust and you have a 2.25% margin, your new fully-indexed rate will be 6%.
• The 5/2/5 comes in when your rate begins adjusting. The first number 5 represents the initial interest rate cap and limits the first interest rate adjustment to 5% (in this case to a maximum of 11.25% - your initial interest rate of 6.25% plus the 5% cap). The second number, 2, is called the periodic cap and limits how much your rate can increase for all subsequent adjustments.  For example, if your periodic rate cap is 2% and your current rate is 7%, then your newly adjusted rate must fall between 5% and 9% regardless of actual changes in the index.  The third number, 5, is the lifetime cap, meaning that over the lifetime of your mortgage, your interest rate can never be higher than 5% over the start rate or in this case 11.25%.
• Finally, remember that interest-only ARMs are eventually recast.  This means the payment is recalculated so that the balance will be repaid over the remaining term of the loan, which depends on how long the interest-only period is and how long your mortgage term is. So if your have a 30 year loan, with 10 years of interest only, when your first ten years are up, essentially you have the remaining 20 years to pay the principal balance plus the interest.  It's like getting a new 20 year traditional loan at the time your interest only portion expires.  This can result in a significant payment increase. By taking your mortgage balance and running it through the interest only mortgage calculator as a fully-amortizing 20 or 25 year loan you can see what the payment may increase to so you know what your risk is.

If you currently have an ARM that is set to adjust, calculate your new mortgage payment by using the example above and plugging in your own loan parameters to understands the risks. If having an ARM in an uncertain economic climate makes you nervous, talk to a loan officer about refinancing to a new fixed rate mortgage or hybrid ARM--you may find some peace of mind.  It might make your payments go up in the short term, but in some cases it can prevent disaster in the future if you're not prepared.




About the Author
Sheryl Landrum is a Loan Officer in San Diego, California and a freelance writer specializing in mortgage issues.